In this episode of the Motley Fool Answers podcast, hosts Alison Southwick and Robert Brokamp are joined by Motley Fool contributor Sean Gates to answer listeners' questions about tricks for timing the market -- spoiler: there aren't any -- allocation advice if you're coming up on retirement, and how you shouldn't feel guilty about prioritizing your retirement over your kid's college fund.
A full transcript follows the video.
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This video was recorded on Jan. 29, 2019.
Alison Southwick: This is Motley Fool Answers! I'm Alison Southwick and I'm joined, as always, by Robert Brokamp, personal finance expert here at The Motley Fool.
Robert Brokamp: Hello, everybody!
Southwick: Hello! We're also joined by Sean Gates because it's the Mailbag episode. Today we're going to answer your questions about what to do right before you retire, timing the market, factoring pensions and Social Security into your asset allocation, and so much more. Woo!
Brokamp: It's so exciting!
Southwick: All that, and more, on this week's episode of Motley Fool Answers.
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Southwick: Hey, Sean! Welcome back!
Sean Gates: Thanks! It's good to be back!
Southwick: Thanks for coming in and helping us tackle this mailbag! And you're going to be coming back soon to help us with a series that we're going to do with Motley Fool Wealth Management [a sister company of The Motley Fool] on different life events, so I'm excited about that!
Brokamp: Yes, it will be very exciting!
Gates: I've read all the comments about how your voices are so wonderful for podcasts, but they don't talk about how nice your faces are for podcasts.
Brokamp: Oh, well, thank you very much!
Southwick: We do have faces for podcasts. All right, let's head to the first question. It's goes to Bro and comes from Jeff. "I am 65 years old and a little less than two years away from my planned retirement date."
Brokamp: Congratulations!
Southwick: "Over the past two years I have been investing my sizable IRA into allocations close to those recommended in the RYR model portfolios for someone in retirement just to be conservative." Aw! They're listening to your advice in Rule Your Retirement.
Brokamp: I know. That's so great! And I'm sorry! No, just kidding!
Southwick: "As a Fool subscriber since the early 2000s, I'm pretty comfortable with buying and holding stocks for the long haul. I am not comfortable in the world of bonds and have only bought into bonds via the bond allocation recommended in Rule Your Retirement.
"About two months ago I sold all the bonds in the IRA to cash. I do get 1.9% on my cash in the IRA so I'm not too anxious to get my money back into bonds, but when should I be thinking about putting all that cash back into bonds? Is it better to be in bond funds or in actual bonds?" Bonds, bonds, bonds, bonds, bonds.
Brokamp: Bonds, bonds, bonds, bonds, bonds. So Jeff, thanks for subscribing to Rule Your Retirement! Of course...
Southwick: Keeping food on the Brokamp family table.
Brokamp: That's right! So the model portfolio for people in retirement is that classic split of 60% stocks, 40% bonds, although really the 40% is out of the stock market so it can be bonds. Could be cash. And particularly with what we call the "income cushion," which is three to five years' worth of portfolio-provided income that you're supposed to get from your portfolio, that's part of that 40%. That really should be safe and I'm perfectly fine with that being in cash.
Because [and we saw this last year], bonds do go down, particularly when interest rates go up. The Fed hiked rates four times last year. The prices of bonds dropped, but because of the interest they were essentially flat for the year, so they did underperform cash. Historically bonds outperform cash by about 2% a year. I'm cautiously optimistic that bonds will beat cash this upcoming year because the Fed is not going to raise rates four times.
But I'm only cautiously optimistic about that because there could be a couple of rate hikes on the way plus [and we got a question about this, too, regarding something I had mentioned in a previous episode], when you look at the bond market it is riskier, particularly the corporate bond market. Much more of the corporate bond market, now, is made up of debt that is just on the verge of falling into junk territory. The bottom line is I'm perfectly fine with you being in cash instead of bonds, certainly in the short term.
Over the long term I do expect bonds to outperform cash, but just by about 1-2%. The riskier the make-up of your bonds, the more likely they actually will drop during the next recession. We saw corporate bonds drop during the last Great Recession. So if you want to play it safe, I'm fine with cash. If you're going to go into bonds, pay attention to the quality of the bonds and if you're going with a bond fund, you can look at that at Morningstar. Click on the portfolio tab and it will tell you what's in there.
The other question was whether individual bonds are safer. They provide more security, but they take more work. You can easily buy individual Treasuries straight from Uncle Sam at TreasuryDirect.gov.
Southwick: The next question comes from Jim. "I was discussing 401(k) plans with a friend recently, and he showed me his statement." Wow, these are close friends! There are not many people in the world I would show my statement to. "He is paying a 5.75% sales fee up front before the ongoing cost of the various funds. On the surface, it would seem that the plan doesn't meet the fiduciary responsibility.
"He said he asked his CEO about the plan and they won't change anything. The company doesn't provide any match, so I told him to stop contributing and use an IRA or brokerage account. Can you explain the responsibility of a plan administrator? Is there anything else that he can do?"
Gates: It's a great question and very inside baseball. The responsibility rolls up to ERISA, which is the regulatory body that governs employer-provided plans. One thing that your friend can do, as a first step, is just make the CEO aware that he has a personal responsibility to provide fiduciary-level advice to his employees.
You can do that in subtle ways. You can give him reports. This is what's referred to as an "interested party." The people who actually administer the plan [TPA people, record keepers, the actual plan administrator] have a direct fiduciary responsibility to their employees.
But they're also interested parties, and under the new fiduciary rule that's being bandied about -- and then specifically under ERISA -- these interested parties also share responsibility. Just making him aware that he could be personally liable for any lawsuits that came against him for high-fee 401(k)s might nudge him in a different direction.
A harder step that you could take is you could initiate a class action lawsuit. There have been several over the last few years that have paid out massively, and they're not hard to prove. A 5.75% front load on a mutual fund will fall squarely in what they call "excessive fee classification." Ameriprise recently paid out $27.5 million. Boeing and Lockheed Martin [had] multimillion-dollar lawsuits. [These lawsuits] will normally be remunerative to the clients above and beyond. So it's base level, punitive damages, and then making clients whole for the fees that they paid over and above.
Southwick: It sounds like he works with a small employer if he's able to walk into a CEO's office and chat. For a class action lawsuit -- it's not a Boeing-size company.
Gates: Right. It might not be class action lawsuit. I just used those examples to say you could take legal action. If you get an independent lawyer on your own, they can also file an excessive fees lawsuit. Now, you could be worried about the ramifications of doing that in a small-employer environment. I don't fault you for that. That's why I suggested the first step be just let him know what he is responsible for.
Southwick: You've got a nice business, here. It'd be a shame if someone filed a lawsuit for your excessive mutual fund fees.
Gates: Exactly. But I think you're also in the right. If lawsuits are on the table, there's a pro/ con decision there, but these things are becoming more and more relevant. More and more lawsuits are coming up and being paid out. It's hard to justify these types of fees inside a 401(k).
Brokamp: The reason the CEO is probably doing it is to save the company money, because it does cost a company to offer a 401(k) and then if they go to a broker or a financial advisor and say, "We want a 401(k) for our company, " she or he will say, "Well, we'll charge you this and make it easy on the employees or we won't charge you much and make the employees pay." That's what's going on here, probably.
The thing is over the last few years there have been many more providers aimed at small businesses with much more reasonable fees, so I would also look out there and maybe have an alternative to offer. Say, "Look, here's someone who's doing this pretty reasonably for small businesses."
Gates: That's a great point. I was going to say Betterment has a Betterment for Business program that's a very low cost and they specifically are trying to check the boxes of the different regulations. I think it's E38 of the fiduciary rules, and so you can present those as alternatives to the CEOs who might not know that there are cost-effective ways to implement 401(k) plans.
Brokamp: And I'll second Jim's advice to his friend in saying that I would first max out an IRA before I participate in a high-cost, no-match 401(k).
Southwick: We did an episode less than a year ago on what to do if your 401(k) plan stinks. That's not the exact title, but look it up. It's a lot of Bro talking about other options and what you should do.
The next question comes from Robert and it's for Bro. Robert writes, "I currently hold 92 stocks with the top 16 positions representing 68% of my total account value.
"I wish I could take credit for being a super stock picker, but the reality is that I've been able to follow the Stock Advisor and Rule Breakers recommendations, hold a lot more than I sell, invest routinely, and stay the course over time." Aw! "I can't say thank you enough for the guidance over the years as it has served me very well." Aw! After reading all that praise, let's move into the question.
"I'm four years away from the minimum age to draw early Social Security and my wife will be eligible to draw early Social Security in two years. We have a very reasonable mortgage that we could pay off if we liquidated our after-tax account investments but may not want to for tax purposes.
"I have three questions. [1] I have read several Guide to Retirement articles that suggest that you should have 10x your current salary saved for retirement. Is that enough? [2] another guideline I've read is that you should draw only 4% annually from your accounts in retirement. Your thoughts on this? [3] Should we pay off our current mortgage prior to retirement or keep it to maintain some kind of mortgage interest write-off during retirement?" Are you ready to go back to No. 1?
Brokamp: Yes, but before I do that I want to point out something else. So, Robert, you mentioned that you're four years from minimum age for Social Security and your wife is two years. That suggests that you might be planning to claim Social Security early. My first thing would be not to do that. In my interview with Larry Swedroe, his basic recommendation is to delay it. Definitely look into that. For most people that's the right thing to do.
The first question was the "Guide to Retirement" and that you should have 10x your salary before you retire. That advice mostly comes from a very well-known Fidelity study and there are other studies that also generally support that one from DFA. Other studies recommend more. T. Rowe Price did a similar type of analysis and suggests that you should have 12x your salary before you retire.
But the thing is these are rules of thumb, and there are lots of factors that would determine whether that's good for you or not. One of them is how much you were making before you retired. If you look at the 2018 recommendations from J.P. Morgan [they have this great J.P. Morgan Guide to Retirement], they would say 10x is fine if you earn $75,000 a year, but if you have a household income of $150,000, you need 13x your salary before you retire. The reason is because Social Security replaces less of your income the wealthier you are. That's just one example of how there are lots of factors that determine this, so definitely go see a qualified fee-only planner to get that answer for you.
The second question was whether the 4% rule makes sense and our thoughts on it. I keep threatening to do a whole episode on this, and one of these days I will. I will say as a back-of-the-envelope rule of thumb, it's OK; but, generally speaking, it's also something that really depends on a lot of situations [your age, your life expectancy, whether you're getting income from other sources]. I would say it's fine if you're just doing a mental calculus of generally how much you could have in your first year of retirement, but I wouldn't rely on it exclusively.
And the third question was whether you should pay off your mortgage. You talked about being able to write it off as a deduction. I'm going to guess you're not actually going to be able to do that anymore. Because of the higher standard deduction from the new tax law, far fewer people will be able to write off their interest. Plus, it sounds like you've had your mortgage for a while and as you own your mortgage, more and more of your payments are principal and not interest, so I wouldn't count on it for any sort of tax deduction.
If you have a lot of cash sitting around earning 1-2% and you have a mortgage in which you owe 3.5-4%, I'd say go ahead. You might want to do that. I feel less confident in terms of selling a bunch of stocks and paying the capital gains taxes to do that to pay off your mortgage. As a safe bet -- as an alternative to cash -- I think it's fine.
Gates: The only thing I would add is this question looks similar to other questions we answer, insofar as you're in a sweet spot. There's a time frame between when most people retire and most people start to recognize most of their retirement income, and it's usually between five and eight years where you've officially retired. You're not claiming Social Security yet. You could delay or postpone that window. Maybe you have a pension that hasn't kicked in, etc. RMDs don't kick in until you're 70.
So there's this window where you can recognize income strategically to manage your tax bracket into retirement. I feel like this is where I add value to folks the most as a financial planner, as it's something that people don't know to ask. I think you're missing it, here, because you even said you're going to claim Social Security potentially early. If you delay, you get a bigger Social Security benefit and could harvest income from other retirement assets [pre-tax assets], strategically now to bridge you, and it would probably lower your lifetime tax liability. These are things that you should be thinking about as you prepare to see a qualified financial planner.
Southwick: Our next question comes from Rob. "I am 51 years old and about two years away from retirement. I am a single man, currently, with no dependents and I have been investing about 30% of my income. I have $300,000 in my tax-deferred thrift savings plan account, $400,000 in my Roth TSP, $150,000 in a Roth IRA, and $300,000 in my brokerage account.
"My TSP accounts are equally split among three index funds [CSI], and the brokerage account is split about 50%-50% between index funds and a handful of individual stocks. I also expect my pension from the military will be approximately $4,000 per month and that my mortgage will be paid off in the next few years.
"What would you recommend I do with these funds upon retirement to maintain a healthy lifestyle [not extravagant by any means] that will allow me to travel occasionally, volunteer my skills and time for a cause, and still leave a healthy sum to charity, school, church, etc. when I die? How should I invest them? Should I combine the accounts? Am I on track for a healthy 30-plus-year retirement?"
Gates: Such a good question! You should also see a financial advisor. We're open at Motley Fool Wealth Management [a sister company of The Motley Fool]. And actually my first response would be, "Man, I want to see your statements. You're single? Show me your statements, sir!"
Southwick: Sean, you are not single, so...
Brokamp: But he's open-minded.
Southwick: Spoiler.
Gates: This touches on a number of things that I run into all the time, and I would say the big piece that you're missing, that would help someone answer it, is how much you want to spend in retirement. You listed all of your assets. I don't know how much you're going to spend. If you want to spend $30,000 a year, you're probably fine. You can do whatever the hell you want.
Most people that I run into, especially people who have been following The Fool for a while, are in better shape than your average bear. Better to the standpoint of they actually could have a very healthy lifestyle on their goals, because their goals are usually modest. So without knowing much more about your situation, I'd say you're probably fine, but we could certainly get more into the weeds.
I would also say one of the things that I fear you've missed, as well, is your savings strategy seems a bit wonky. I'm presuming that you have a decent income and you probably made the calculus that you wanted to save after-tax to Roth money because that's the most tax-efficient growth that you can get. But you also find yourself at a young age with a military pension of being able to retire well with that sort of pension, and you also get to dictate your income in retirement before you turn on Social Security and before you turn on your RMDs.
And so it might make more sense to save pre-tax rather than Roth now, claim the immediate tax deduction that that affords you, and then start harvesting income in between the years that you retire and turn on your various income sources. Again, this is setting yourself up for the best success in retirement that people often forget to ask about.
Brokamp: He asked about what to do with the accounts, too. The TSP [the thrift savings plan] is basically a 401(k) for federal employees, and all their funds have these letters. He has the CSI. C is basically common stock in the S&P 500, S is small-cap, I is international. It is an extremely low-cost, very efficient plan. For most people who are in the TSP, I don't see a reason to move out of that unless you want to be able to use some more of that money to buy individual stocks.
This addresses a lot of questions we receive when someone has left their employer and wants to know what to do with their old 401(k). One, you even have a choice to leave it there, and sometimes you don't. They're going to kick you out, eventually, and it's better if you take the initiative to move it.
No. 2 is costs. We talked about the previous person with the horrible plan. You would definitely want to move out of that if you can.
And then No. 3 is options. Again, in the TSP you just have index funds and you might be perfectly happy with that, but if you want to have other options, you would move it out of the plan. For him it's probably fine to leave the money, but for other people who ask what to do with old 401(k)s, those are things to consider: costs, options, and other choices that you might want.
He also asked about a 30-year retirement, but he's planning to retire in his early 50s, so he really should plan on a 40-year retirement.
Gates: Absolutely. And one other thing we didn't touch on is the investment plan. Here, again, it's such a unique perspective because if you're in as good a shape as I think you are, one of the benefits of financial planning that people don't appreciate is that if we run the projection specific to your situation, it's very likely that you could choose what you want your investment plan to look like.
You could just stay in cash -- just raw cash earning you 2% -- and probably meet your financial goals, but you might die with less money than you would want. Or you could be very aggressive and die with a lot more money, but you open yourself up to near-term risk and how you handle that. You could choose anywhere along that spectrum, but it's up to you and what you value. Do you want to die with a lot of money or do you want to have a more luxurious life now and maybe be able to sleep better at night? These are just conversations that are worth having for a lot of folks that don't know where to turn.
[...]
Southwick: The next question comes from Brett. "I understand that ETFs are more tax-efficient than mutual funds, so it makes sense to use them in retail brokerage accounts, but assuming a mutual fund and an ETF invest in the same index and have the same expense ratios in a tax-deferred account, it seems the mutual fund is a better choice because it's easier to invest in a varying amount of cash and can be more hands-off for long-term investing. Is there another reason to choose the ETF in a tax-deferred account other than real-time trading?"
Brokamp: I'll start with explaining what he means by "real-time trading." An ETF is a fund [that's the F] that trades like a stock. If it's two o'clock, the market's open, and you want to buy or sell a certain ETF, you pull up the quote from your broker, you place the order, and you're probably going to get very close to that price.
Traditional mutual funds only trade and are only valued at the end of the day after the market is closed. So if it's two o'clock and you're thinking of buying or selling an open-end mutual fund, you can pull up the quote and see what it was worth the day before, but you don't know the price you're going to get if you place that order. That is definitely a benefit of ETFs.
He talked about ETFs being more tax efficient. That's generally true, but not always true, and you can find out the tax efficiency and compare a fund to an ETF at Vanguard. You just put the tickers in the site, you click on a tab that says Taxes, and you'll find the tax efficiency ratio.
Just as an example, one of the biggest ETFs, the SPDR S&P 500 [the ticker is SPY] is actually less tax-efficient than the Vanguard 500 traditional mutual fund, so ETFs are not always the most tax efficient.
Southwick: Can you step back and define what makes something more or less tax-efficient?
Brokamp: What Morningstar does is it calculates how much you would have lost to taxes if you held the investment in a taxable account. The difference between those two funds is small, but regardless, the Vanguard 500 mutual fund is more tax-efficient.
Gates: And mutual funds are a collection of dollars that then goes to buy a series of stocks. You as an individual investor -- when you buy into that mutual fund, you might be buying into stocks that have already appreciated in value because it's already been accounted for, for all of the other investors that they have, and then they're going to distribute you a pro rata portion of the capital gains of those shares, even though you didn't participate in the growth. And ETFs do a better job -- not a perfect job -- but a better job of being more liquid in attributing individual shares to the price that you enter in because they trade intraday.
Brokamp: Right. It just varies from fund and ETF. You want to look specifically at your funds if you're buying them in a retail account. But as Brett is pointing out, he's in a tax-deferred account, so he doesn't care. He does also point out another benefit of mutual funds in the sense that if you want to invest $200 in a mutual fund, you send in the $200 and it will get invested.
With ETFs, they have a share price and you have to round up or round down. If you have $200, chances are you're not going to be able invest all of that because each share has its own price. It's like buying an individual stock. Some brokerages will let you buy partial shares of ETFs, but most won't, so that is a benefit to mutual funds.
And then finally there's commissions. To buy an ETF from a regular brokerage, chances are you'll pay a commission for every purchase. That said, more and more brokerages are offering commission-free trades on ETFs. You would also want to look at how much you're going to pay for each purchase of the ETF vs. the price of a mutual fund. For most open-end index mutual funds, you're probably not going to pay a commission.
The bottom line, here, for Brett is you need to look at the specific fund and the specific ETF and compare all those costs. To be honest, if it is truly following the exact same index and they have similar expense ratios, it's probably not going to make that big of a difference.
Southwick: When I hear questions like this, it makes me feel like I'm not worrying enough about how I'm investing my money.
Gates: I think you're probably in a better lane than that.
Southwick: It sounds like Brett obviously cares a lot about this, but then it makes me think, "Oh, I've never even considered if I'm being tax-efficient." Then I feel intimidated and horrible about myself.
Brokamp: You shouldn't.
Gates: Nope.
Southwick: OK, thanks! Brett, you're better than me!
The next question comes from Bill. "Based on our Social Security reports, my wife and I can estimate the amount of cash we will be paid each month upon retirement. When evaluating our portfolio allocation, is it better to ignore those future estimated payments, or should we factor them into our allocations? If we consider it as cash in the bank, it would allow us to have more invested in equities today."
Gates: This is a great question, and it brings up a lot of issues. I would say the first one I want to call out is something called "sequencing risk." This is more of a behavioral type of question, but if you count Social Security income as a portion of your asset allocation, I think it's fair to do so [covering off on the safer investments like bonds or cash], but what it robs you of is having a placeholder value in your account that doesn't move.
So you've accounted for your stable resource in your asset allocation from an income source that hasn't started to arrive. You could have all of the rest of your assets be invested in stocks, but now your entire value that's in stocks is going to move wildly with the stock market. From a behavioral standpoint that's very difficult to digest, because this is just a mental accounting issue. You're not really going to be paying attention to the money that's in Social Security, because it's not coming to you yet.
What's important from a sequencing risk perspective is that if all of your money that you need to spend from [in this case, your investment assets], are in stocks and you go to draw on that money for your retirement needs, those stocks could be depressed in value temporarily because of the stock market; and it's very difficult to come back from an early withdrawal at depressed prices early in your retirement. So having a stable placeholder inside of your account for those occasions is critical to avoiding sequencing risk.
Brokamp: That's why we have the income cushion that we talk about in RYR. You at least have something that is going to hold up no matter what happens to the stock market when you're in retirement.
Southwick: The next question comes from Kurt. "We hear so often that investing in large-cap funds in the U.S. stock market is like, 'betting on America.' For those of us with federal or military pensions, a large chunk of our future retirement income is already directly tied to the U.S. government's ability to pay in the future, which is arguably dependent on the success of the U.S. stock market. Considering this, should people who will depend on a federal pension invest more in international or other investments, or should we double down on America?"
Brokamp: I thought this was a really interesting question because I've never considered it or seen it discussed before. The overall principle of factoring your pension into your overall asset allocation definitely makes sense and it's similar to what we just talked about with Social Security. If you were getting your pension from a car manufacturer, I would definitely say that maybe you would want to hold off on buying too many car stocks.
The government is a little different. Previously, we would have all said that a government pension is pretty darn safe and you don't have to worry about things. Then comes the shutdown. I read on Military.com where 50,000 Coast Guard retirees are at risk of not getting their pension check on February 1st due to the shutdown. Now, I think they'll get their check and if they don't get it February 1st it will eventually come.
But I do feel like we're almost in new world in terms of where we question things that we always took for granted. So as Kurt brings up the question, I feel that maybe you should. One the one hand, I definitely think every retiree should have some international investments, but maybe you should have a little bit more if you're getting your pension from this big company known as the United State of America.
The flip side of that is that international stocks are more volatile and volatility can be very worrisome to retirees because retirees don't often have the time to ride out a bear market and they're forced to sell when things are down. Furthermore, international stocks have an additional risk in that they have currency risk. Even though the stocks, themselves, might be fine, if the dollar moves in a different direction than the currency of those companies, your purchasing power may come down. That's standard financial planning advice -- that one reason to reduce your international exposure is to reduce your currency risk, because you've got to turn your portfolio into dollars that you spend.
I don't have a really good answer for you. It's an intriguing question that I'll have to ponder some more, but I don't think these days it's a bad idea to consider having a little bit more if so much of your retirement is relying on the government.
Southwick: Bro's going to have to hit the books on that one.
Brokamp: I'm going to have to cogitate on that one a little longer.
Gates: I just would offer up a few data points on perspective. Outside of this commentary [which I think is valid], international stocks tend to make up more than 50% of global market capitalization. A lot of other robo-advisors who have smart people coming up with asset allocation guidance for thousands of clients tend to have their portfolios around 40% in international.
When I run into clients at Motley Fool Wealth Management [a sister company of The Motley Fool], the tendency for Foolish investors is that they are severely underweight international stocks. That's partly our fault. We don't have an international service to speak of, but it's just something to think about in that most people are underweight international stocks and, to be perfectly candid, those people have been rewarded over the last eight to 10 years, because international stocks have not done well over the last eight to 10 years and it's a little bit of a compounding factor. Just some stuff to think about as you weigh this quandary.
Southwick: The next question comes from Eric. "Everyone says you aren't supposed to try to time the market because you can't win. But what about changing portfolio allocations in line with the business cycle, especially since there's a degree of certainty in the stage of the business cycle like the seasons. For example, right now people are anticipating the end of the current bull market and possibly changing their allocations. Are there good rules of thumb or books you can recommend about timing the business cycle?"
Gates: My answer to this is going to sound snarky and it partly is. I have folks who call me and always start the conversation with, "Well, I don't practice market timing, but what if I did this?" It's just a fancy way of rationalizing market timing and that's what you're doing. At least you called it that at the onset of your question. But what you're trying to do is time the market, and it's a fool's game. You can't do it. I could provide you with books to recommend how to time the business cycle and I could also provide you books that did it based on weather, or charts, or some other random bulls**t that doesn't matter, but it doesn't work.
So what I would suggest as an overarching thesis to think about as a different mechanism is just good, old asset allocation. If you're worried that we're at a market top of some kind, and you find yourself in, let's say, an 80% equity, 20% bond portfolio, or some variation therein [more weighted toward equity], shift your asset allocation less in equity.
You can talk with someone or we can come up with guidelines on what it would be, but that should be your method of market timing. Shift out of equities into a conservative allocation, do so on some time-based regimen [let's say quarterly or every six months] and then when you see the market pullback that you think you know is coming, shift back to where you were. That's the only version of market timing that I suggest to folks, because it's the most implementable and regimented that you can follow.
Brokamp: The bottom line [and I may have said this before], but I've been in this business, now, for more than 20 years and I've never found anyone who's successful at doing this. Eric compares the business cycle to the seasons, but the truth is the business cycle is not as predictable as the seasons, and right now we're in the second-longest expansion in history. If you sold your stocks just because we had exceeded the average of five years of an expansion, you would have missed out on the next four years. It's just not that systematic.
Gates: And the old saying is there's more money lost waiting for a pullback than in the pullback itself. I run into this all the time -- where people got out in 2008. Maybe they were right. Maybe they got out before the crash, but then they stayed in cash for 10 years and they have watched their portfolio flatline; whereas, people who stayed in are far higher than they would have been even accounting for the drawdown. I just can't preach against market timing enough.
Southwick: There was an article on MarketWatch.com where they looked at the worst market timer in the world. They did this model portfolio of someone who always sold and bought at the wrong time; but because they stayed in, they still did very well.
Brokamp: Right. They purchased at the top of the 1987 market and the top of the 1973 market -- all those -- and they still came out fine.
Southwick: The next question comes from RB. "My wife and I had our first child, recently." Oh, congrats! "I'm 46 with about $50,000 in a rolled-over 401(k) from a previous job I haven't contributed to in years. My wife is 34 and a registered dietician who just started her first 401(k) a few years ago. We have about $20,000 in the bank not doing much of anything and our only debt is a house payment we can easily afford. We have a couple of questions.
"One, my new job offers a 401(k) option. Should I begin contributing to that or would it be smarter to open my own Foolish account with a portion of our savings? Two, any suggestions for the newborn?"
Brokamp: Congratulations on the new baby! As we discussed earlier, you should definitely be investing in an IRA first if your 401(k) stinks and you don't have a match. That said, from what I can tell, here, you're in your mid-forties and you've saved $50,000 for retirement. You're actually a bit behind.
If you want to be on track to retire at some point in your mid-to-late sixties, you really should be thinking of maxing out maybe both a 401(k) and IRA. I don't know your situation. You might find that difficult to do, but you are behind in terms of your retirement savings. Just maxing out an IRA is not going to get you to where you want to be. Again, you can see a fee-only financial planner or even use a retirement calculator to give you an idea of how much you should be saving.
That brings us to the second question and that is investment suggestions for the newborn. Your priority, in my opinion, is your own retirement at this point. You should be worried about that and then, maybe, think about college for the newborn. In that case you'd be investing in a 529 plan. If you still want to learn about investing for kids and maybe teaching kids how to invest, I highly recommend the first episode of the Rule Breaker Investing podcast from this year in which several Fools, myself included, sat around the table with David Gardner and discussed how to do that. But right now your priority is your retirement.
Southwick: And don't feel guilty about that!
Brokamp: Don't feel guilty about it!
Gates: Not at all!
Southwick: The next question comes from John. "My wife's pension payments from the state of Texas start next year. The commencement is based upon the Rule of 80 [age plus years of service] and there's no benefit to delaying. I'm afraid that this will jettison us into a higher tax bracket causing us to pay more taxes next year. I'm currently maxing out my 401(k) at $18,500 and we are also putting the maximum into her traditional IRA.
"Are there any other tax-deferred investments available to us other than a health savings account? We currently have good insurance with my employer and her pension will also provide her with BCBS coverage. Or an educational IRA? Our son enlisted in the Air Force, is discharged and working for Boeing, and will have a GI bill for school if he wants to go back."
Gates: The short answer is not really. You could save in a quasi-tax-deferred way with certain life insurance policies or even annuities of some kind. I'm not suggesting that that's a good idea. It's often a bad idea. What I would suggest is to definitely take a look specifically at the pension payments, because pensions are a whole ball of wax, and oftentimes there are numerous options that you have for pensions.
I took a look at the state of Texas pension payments. It doesn't seem like it has as many options, but it does seem like it offers a way to take a partial lump sum for certain employees, and the way that you framed it is that that's not an option for you. You want to be careful. If you could take a partial lump sum, you could roll that into an IRA and it would reduce your monthly pension income by a corresponding amount and therefore you could manage your tax bracket better.
But I think this is more trying to give broad advice to people. If you have a pension, you should consult a financial advisor because they can help you figure out what the best mix of income recognition is for you, whether it's a lump sum rollover, partial lump sum rollover, straight life annuity, 50% joint life annuity [an annuity in this case is referring to the pension payment and not an annuity product], but those are critical things that you need to be thinking about.
And I would say you're in good shape. If you have to pay more in taxes because you have so much money in retirement you don't know what to do with, count your blessings.
Southwick: Right!
Gates: There are worse problems.
Brokamp: Worse problems, yes. I'll just point out a couple of things that John mentioned in his question. He mentioned that he's maxing out his 401(k) at $18,500. This question came in at the end of last year. Just so everyone knows, the max has gone up to $19,000 for those under 50. It's $25,000 for those 50 and older.
He also mentions the option of the education IRA. That's now called the Coverdell. He suggested he would do it for his son. One thing about the Coverdell is once you put the money in, the money has to come out by age 30 as opposed to a 529. That's one reason why we like 529s. But if you were considering that as some form of tax deferral [and actually it's tax-free if you use it for qualified expenses], you won't be able to leave it in there, long, because the money will have to come out by age 30.
Southwick: The next question comes from Mark. Mark writes, "Two IRA questions that I need clarity on. I am allowed to have both a Roth and a traditional IRA, correct? And I can only contribute a max of $6,000 [I'm 37] between both accounts? Not into each one?"
Brokamp: That's an easy one. Yes, you understand it. The max for you, as someone who's under 50, is $6,000. You could split it up among 20 IRAs, but the total has to be $6,000 and it's the same with 401(k)s, too. You can contribute to a Roth and a traditional as long as the total does not exceed the max of $19,000. The only exception is for some people. If they have a 457, as well, they can max out both of those in some cases.
Southwick: The second question. "If a traditional IRA is funded with pre-tax dollars, how do I fund it? Once I receive my bi-monthly salary, taxes have already been taken out. Is this remedied by tax deductions during filing?"
Brokamp: And the answer to that is also yes. You just get the deduction on it. But it's important to know that the contribution may not be deductible if you are covered by an employer-sponsored plan, like a 401(k), and you make above a certain amount. For 2019 those amounts would be for single, it starts phasing out if you have an adjusted gross income above $64,000. If you're married and you have a plan, your eligibility to deduct those contributions starts to phase out at a gross income of $103,000. And if you're married and you're not covered by the plan but your spouse is, then it starts to fade out above $193,000. Just because you contribute to a traditional IRA doesn't necessarily mean it will be deductible.
Southwick: And our last question comes from Adarsha. "I am a software engineer in California. I am paid well [$200,000 plus], save the maximum in my 401(k) and max out my ESPP. I am from India and currently on the H1-B visa program. Due to visa issues for Indians, my wait for a green card is six to 10 years. This is frustrating, but life must go on.
"I would ideally like to buy a home in the next three to four years. Houses in the Bay Area where I live cost above $1 million and down payments run in the range of $200,000 plus. I already have $40,000 saved for this purpose. My question. What should be my strategy for saving for the down payment given the time horizon? Currently I have this money in CDs which are locked in for three months, and I renew them every three months and then reinvest the interest. There is some uncertainty that after three to four years I might not buy a home due to the risk related to the visa. Can you give me some advice on what could be done to this down payment money in that scenario?"
Gates: I'll say first that I sympathize with you. My wife is on H1-B and also could have to wait a long time, so I'm sorry to hear about that.
Southwick: Even though she married you? That doesn't speed up the process?
Brokamp: I thought that was the reason she did it.
Gates: That's the only reason she did it. If you want to get married, I also offer visas. Just show me your statements. She would get a green card through me, through the marriage. Unfortunately that process takes between 12 to 36 months, so it shortens it, but it's still a long time, essentially.
Your question is a tough question. I think we probably want to take a step back in terms of how we're evaluating this. I understand the desire to buy a home, but because of the precariousness of your situation in that you could have to go back to India, and you're in San Francisco where home prices are ridiculous, I think we would want to just have a bigger conversation around whether it's worth buying a home in San Francisco rather than trying to figure out if you want to buy a home how you should do it. I don't mean to dismiss your question, but I think that's a more important question.
To the specifics of your actual question, I think at best what I would suggest outside of cash [because we have this rule where if you need the cash within three to five years, it should stay in cash], there should be not much risk to it.
The only thing I would offer more risk-seeking folks is that you could create a taxable brokerage account, invest it in some diversified asset-allocated portfolio, say, 50%-50% [50% equity, 50% bonds], and you could consider applying margin to that account to help with the down payment.
Like I said, this is for risk-seeking individuals, because you're breaking the three-to-four-year guideline and you're going on margin on an account that fluctuates in value, but it helps in certain situations depending on how you structure it. Seek financial advice if you want to implement this.
Brokamp: We've talked before on this show about how sometimes the benefits of home ownership are greatly exaggerated.
Southwick: Do we all want to take turns to [tell] our own stories?
Brokamp: [laughs] We'll save that for the home-buying episode we have coming up.
Southwick: We'll save that for the home-buying episode.
Brokamp: Especially when you have to pay $1 million for the house, you add that to the uncertainty of his visa status and the whole discussion about immigration in this country, in general, and I would not be rushing to buy a house. Certainly it makes sense to start saving up for it now because you want to be ready if and when your citizenship status has been decided. With that said, I would not rush to buy one right now.
Gates: And there are cool things. I'm always interested in learning new ways to address common themes that I pull out of questions, and I think the underlying question here is that you're paying rent. You want to buy a house because you're paying rent and in San Francisco rent is ridiculous and it feels like you're burning up money.
There are start-ups beginning to come to the surface where they're actually collecting rent [you sign up for a contract] and they're giving you the potential for future ownership in a particular building. You could be buying a condo by virtue of the rent that you pay them. So keep your eyes out for interesting products like that as you think through your situation as an alternative to just feeling like you have to buy a home.
Southwick: Well, guys, that was it! Those were the questions! But I have postcards to talk about because some postcards came in.
Brokamp: Let's do some postcards!
Southwick: Let's do some postcards! Josh sent postcards from Japan and a cool little wine bar in Culver City called Hayden. I sent Josh a link to my "Learn Japanese" audio files, so there is proof that he actually went to Japan and used them.
Yoshi sent a card from Wellington, New Zealand. Yoshi is there working on a holiday visa trip. That looks fun.
We also have a card from Lee from New Zealand, where the show distracts him or her from the ugly scenery. So look at that!
Brokamp: That's so ugly!
Southwick: That's pretty rough. [Doubtful sound.]
Brokamp: It's not ugly.
Southwick: It's not. It's beautiful!
Brokamp: It's quite gorgeous!
Southwick: Our favorite swimmer, Jim, is living the dream by living a month in Thailand. Also a real ugly spot, as you can see.
Monica has perfect handwriting. She sent a card from Melbourne. She wanted to share with us her favorite Aussie lingo that she learned. Spit the dummy!
Brokamp: What?
Gates: Spit the dummy?
Brokamp: What does that mean?
Southwick: A dummy is a pacifier.
Gates: I take it back.
Southwick: So if you spit the dummy, it means you're throwing a temper tantrum and acting like a child.
Brokamp: I've got to remember that one!
Southwick: Isn't that a good one? I love that! And then we also have a card sent from Los Angeles but purchased in Cabo by Kenneth. So thanks, everyone, for keeping the cards coming in, even though it's the dead of winter! It's maybe the most depressing, ugliest day outside in Alexandria, right now, so it's nice to look at all these postcards and see that it's beautiful somewhere.
Brokamp: Yes.
Southwick: But not here.
Gates: We're with you in spirit!
Brokamp: That's right!
Southwick: Sean, thank you so much for coming on the show and helping us answer these questions!
Gates: Thanks for having me!
Southwick: Like I said, we'll see you in a couple of weeks to talk about what you need to know with your finances when you get married.
Gates: That sounds great!
Southwick: The show is edited scenically by Rick Engdahl. For Robert Brokamp, I'm Alison Southwick. Stay Foolish, everybody!
